Citi Personal Wealth Management

The Fed
Sends a Signal

Market Reaction: June 22, 2021

Key Thoughts

Back in early February, we wrote a piece claiming that if inflation continued to tack higher over time, then investors may start to debate whether or not a tapering of Fed asset purchases or a raising of interest rates could occur sooner than anticipated. At the June Federal Open Market Committee (FOMC) meeting, the Fed essentially acknowledged those concerns with Chair Powell emphasizing the conditions for rate hikes will likely be met sooner than expected (the Fed originally projected there would be no rate hikes until after 2023). A full two years from now.

The Fed’s so-called dot-plot, which the U.S. central bank uses to signal its outlook for the path of interest rates with each dot representing the interest rate forecasted by one of the 12 members of the committee, now shows two rate hikes in 2023. While not an official forecast and a moving target, it represents a more hawkish tilt in the Fed’s monetary policy. Importantly, the first rate hike will likely not occur for another year or two.

Chair Powell reiterated that inflation is likely to be largely temporary, but he did acknowledge the risk of even higher inflation as demand rebounds faster than supply. He also stated that the U.S. would see a stronger labor market “pretty quickly.” While total U.S. employment remains 7.6 million jobs below its February 2020 level, about 1/3rd of those jobs are in the leisure and hospitality sector, which should rebound noticeably as vaccination plans turn into vacation plans. The pending expiration of pandemic-related unemployment insurance programs and the reopening of schools may also encourage workers to re-enter the workforce this fall.

Citi Research expects the Fed to make a tapering announcement in September and to begin slowing the pace of its monthly bond purchases in December 2021 (though early 2022 also remains a viable option). As our colleagues highlighted in their CIO Strategy Bulletin: An Early Call: The Beginning of the End of Easy Money, this likely marks the very early beginning of monetary policy normalization. In response, financial markets have sold-off with the S&P 500 down about 1.7% at the time of this writing with the Financials sector down 5.2% as the yield-curve flattened (the difference between the 10-year U.S. Treasury yield and the 2-year U.S. Treasury yield). Traditionally, a steeper yield curve is positive for banks as it increases their net interest margins (see figure 1).

Figure 1. S&P 500 Banks Index vs. the Yield Curve (10yr Treasury Minus 2yr Treasury)
Figure 1: Banks Tightening Credit Conditions for Commercial and Industrial Loans vs. Real GDP
This line chart shows S&P 500 Banks Index vs. the Yield Curve from June 2020 to June 2021
Sources: Haver Analytics and Citi U.S. Wealth Management as of May 12, 2021. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance does not guarantee future results.

However, we see the likelihood of a bear market as low as history suggests that the stock market can absorb an eventual and gradual tightening of monetary policy. Following the Global Financial Crisis, the Fed also normalized its balance sheet by announcing in December 2013 that it would reduce its monthly pace of bond purchases from $85 billion to $75 billion and would continue to reduce purchases in “further measured steps” if the economy continued to perform as expected. While at the time investors wondered if the stock market could survive without the support of quantitative easing (or QE), the S&P 500 went on to post positive annual returns in each of the next four years with real U.S. gross domestic product ranging between 1.7% and 3.08% while the Fed normalized its balance sheet and hiked interest rates 5 times between 2014 and 2017 (see figure 2).

While we suspect that financial markets will remain volatile as both monetary and fiscal policy adjust later this year, we think that mid-cycle equity returns should still be rewarding in the years ahead as the U.S. economy is still likely to experience above-trend growth for some time with consumer spending supported by a tremendous $25.5 trillion rise in household net worth between the first quarter of 2020 and the first quarter of 2021 and an elevated personal savings rate of 14.9%.

Figure 2. S&P 500 Total Return and the Fed’s Balance Sheet
Figure 2: ISM Model vs. U.S. Inflation
This line chart shows the S&P 500 Total Return and the Fed’s Balance Sheet from 2011 to 2020
Sources: Haver Analytics and Citi U.S. Wealth Management as of December 2020. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance does not guarantee future results